The term adverse selection was initially used in insurance. It describes a scenario wherein an individual’s demand for insurance (the tendency to purchase insurance and/or the amount purchased) is positively correlated with the individual’s risk of loss (higher risks buy more insurance), and the insurer can’t allow for this particular correlation within the cost of insurance. The latter scenario is occasionally referred to as “regulatory adverse selection.”
The potentially adverse nature of this happening can be illustrated by the connection between mortality and smoking status. Non smokers, normally, are more likely to live longer, while smokers, normally, are more likely to die younger. If insurers don’t change prices for life insurance according to smoking status, life insurance will be a better purchase for smokers than for nonsmokers. So smokers may be prone to purchase insurance, or may often purchase larger quantities, than nonsmokers, therefore increasing the typical mortality of the combined policyholder group above that of the typical populace. From the insurer’s perspective, the higher mortality of the group which chooses to purchase insurance is undesirable. The insurer increases the amount of insurance so, and as a result, nonsmokers may be less inclined to purchase insurance (or may buy smaller quantities) than they’d buy at a reduced price reflective of their lower hazard. The decrease in insurance purchases by nonsmokers is, in addition, undesirable from the insurer’s viewpoint, and maybe also from a public policy viewpoint.
Moreover, if there’s a variety of raising danger classes in the people, the upsurge in the insurance cost due to adverse selection may lead their insurance to not be canceled or not renew by the lowest remaining risks. This encourages a further increase in cost, and therefore the lowest remaining hazards cancel their insurance, leading to a further price increase, etc.
This threat selection procedure is known as underwriting. In many countries, insurance law includes an “utmost good faith” or uberrima fides doctrine, which requires prospective customers to answer any underwriting questions asked by the insurer fully and frankly; if they fail to do that, the insurer may later refuse to pay claims.